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A Quick Explainer on Tax Brackets

7 Dec

It is a common belief that moving into a higher tax bracket will cause you significant financial hardship. People have given away large sums for a tax deduction or even accepted lower pay believing they are actually saving money by maintaining a lower tax bracket. This post explains why this is incorrect and illustrates what a tax bracket transition really means for you.

The Myth
The basic belief is that tax brackets are retroactive and that all income is subject to your highest tax bracket’s percentage rate. The chart below illustrates the tax amounts a person would be subject to if this logic were applied.

Invalid Tax Bracket

The Reality

Only the income above the minimum amount for any given tax bracket is subject to that bracket’s rate.

For example:
If you are filing single and made $30,000 in 2008 you would be in the 15% tax bracket. Your first $8,025 would be subject to 10% in taxes. The remainder ($21,975) would be taxed at 15%.

This chart illustrates the actual tax breakdown for each taxable income group:
actual

This detail view illustrates the different tax brackets as they apply to the income of a person filing single. The red line is a reference to help illustrate the slope of the tax amounts below.

actual-single

This final chart illustrates the myth vs reality when one’s income moves from one tax bracket to another. The blue vertical bars indicate the tax brackets. The red zone illustrates the incorrect assumption that your tax rates apply retroactively. The green zone is your true net income.

income-single

Summary

This post should dispel the myth that your current tax bracket applies to 100% of your income. While taxes are complicated by many factors, this basic rule still applies. Don’t let yourself be fooled into believing that you are actually saving money by lowering your tax bracket. You should make tax-deductible donations as you see fit, but don’t think you’re saving any money by doing so.

More information
IRS 2008 tax tables
Chart source data (Google Docs spreadsheet)

 

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Lessons Learned House Hunting in Seattle

16 Apr

House Graphic

Right now is a tedious time to be trading Seattle real estate. While the nation at large is experiencing a deflation in housing values, the Seattle market is stubbornly fluctuating between plateau and boom days.

A large number of properties are going unsold for 90+ days [zillow.com] while others are subject to irrational bidding wars. Part of me wants to sit it all out for another six to twelve months, but my better half insists that we need a house.

And so, we are in the market for a house.

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The 30 Year Mortgage Paradox

19 Oct

Imagine you were considering your options on a $350,000 traditional home loan. Assuming you have a FICO score of 725 (US average(1)), your interest rate might be 6.259% for a 30-year fixed mortgage(2). At the end of 30 years, you’ll own your home outright for a total cost of about $776K–that’s $427K in interest(3).

By contrast, a 15-year loan will net you a lower interest rate of about 6.011%. Your monthly payments will be a little bit more, but you will own the home in half the time for a total cost of about $532K–only $182K in interest.

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